Cloud exits: How the M&A and IPO markets are changing expectations for cloud tech companies

Cloud technology companies have increasingly become acquisition targets rather than IPO candidates, according to a new research report. But investors and analysts say that could start to change in the year ahead.

In its just-released “State of the Cloud Report 2017,” venture capital firm Bessemer Venture Partners (BVP) reported that the value of merger and acquisition activity in 2016 for cloud companies was almost four times the value of cumulative activity in 2015 (or any other year since 2009).

BVP’s analysis showed that public cloud companies between 2009 and 2017 represented a total market value of $300 billion – and that 40 percent of that market capitalization has now been acquired. The biggest examples: the $26.2 billion acquisition of LinkedIn by Microsoft, the $9.3 billion purchase of NetSuite by Oracle, and SAP’s $8.3 billion swallowing of Bellevue-based travel and expense management powerhouse Concur.

That rise in mergers and acquisitions is in stark contrast to the last cloud IPO numbers cited by BVP. The firm reported that there were only five major cloud sector IPOs in 2016 (Twilio, Blackline, Coupa, Apptio and Everbridge), which raised a total of $6.7 billion. That number is down dramatically from the $15.6 billion raised in 2015 from the seven cloud sector IPOs by Atlassian, Shopify, Box, Mindbody, Appfolio, Instructure and Xactly.

With that backdrop, cloud analysts and investors seem united in the view that IPOs, mergers and acquisitions and private investment will continue to grow throughout 2017.

More tech IPOs expected

Matt McIlwain

Matt McIlwain, managing director of Seattle-based Madrona Venture Group, told GeekWire this week that he expects to see growth in IPOs overall this year.

“We do expect there to be more technology IPOs in 2017,” he predicted. “It is odd that the stock markets are at all-time highs, but 2016 was a meager year for IPOs.”

He noted that Madrona was the only venture firm nationwide that was a major investor in two tech IPOs in the past year, Apptio and Impinj, both Seattle-area companies.

McIlwain also suggested that the next wave of IPOs could start fairly quickly.

“We understand that many technology companies in general — and some cloud-related companies — are confidentially on file with the SEC,” he said. “Many of those companies are planning to go public in the second or third quarter. If market conditions hold, we should see that happen post the Snap IPO.”

“IPO is definitely back in the playbook for growing tech companies,” he said. “In the last six months, we have been asked to keep an eye out for IPO-experienced (chief financial officer) and (general counsel) candidates for a half dozen companies, all of which are going through their 404-compliance process to be IPO-ready in late 2017. We had zero inquires in 2014 and 2015. Based on these dialogues, I am confident that the recruiters would report a significant increase in demand for IPO-ready management talent.”

Rodney Nelson, an equity analyst at Morningstar Inc., attributed part of the recent slowdown in cloud IPO activity to the broader national political environment.

“I think the general uncertainty of the US political situation is probably contributing to the tight IPO environment in tech,” he said – although he further suggested that post-IPO performance by some cloud companies could also be putting a damper on new public offerings.

“We’ve also seen a couple of recent IPOs (Acacia Communications and Twilio come to mind) that absolutely flew out of the gate and then went through steep sell offs,” he said. “I’m sure there’s also some trepidation over the market being at all-time highs, and some question of ‘how much higher can we go?’ certainly creeps into the minds of founders, but I think we’ll see VCs who are looking for exits potentially push more aggressively for an IPO in 2017.”

He said that even the stodgiest software companies have realized that the cloud is the future, and the power of the recurring revenue model is increasingly enticing to firms that can understand the tradeoff between short-term margin compression (due to software and services being provided by more inexpensively to customers through the cloud rather than through traditional software licenses) and the long-term lifetime value of an individual customer that renews a subscription yearly.

“There are still some large companies that could come up in the rumor mill,” Nelson said, citing ServiceNow and Workday as the highest-quality Software as a Service (SaaS) properties that have a reasonable chance of being acquired. He said Salesforce “remains best in breed and would require a massive offer to take out,” but he believes more attention will be paid to companies such as HubSpot, Zendesk, and other companies of that size.

Nelson added, “The power players are flush with cash and/or have balance sheet flexibility to take on new debt or issue new equity to finance deals, and if the big guns like Microsoft and Oracle can repatriate cash at a lower tax rate (due to expected corporate tax cuts under the new Trump administration), that could spur deals as well.”

The cloud revenue lifecycle

Regardless of the external factors at play, BVP’s analysis shows that one of the biggest determinants of how much investment a cloud company will get depends on how well it manages revenue growth before, during and after a public offering.

Investors want to see more evidence of customer retention, upsell and profitability (on a lifetime value basis) and they want to have confidence that the market and the executive team can support long-term scalability.

BVP shows varying expected levels of combined compound annual revenue growth (plus free cash flow) at different stages of a company’s growth. During what it defines as the “expansion” phase (from $30 million to $60 million in annual revenues) BVP says it has seen a 70 percent growth rate, which declines to 50 percent by the time the 43 public companies in its Cloud Index hit IPO (with annual revenues of around $100 million) and then down to 30 percent when they are operating as public companies with $150 million or more in annual revenues.

Madrona’s McIlwain agreed that investors are looking for different kinds of performance from cloud companies at different stages, with a greater focus now on the later stages of development.

“The bar is higher and more metrics-driven at a later stage.” he added. “Investors want to see more evidence of customer retention, upsell and profitability (on a lifetime value basis) and they want to have confidence that the market and the executive team can support long-term scalability.”

Morningstar’s Nelson also noted that valuations for cloud companies can be driven up by bidding wars, citing Salesforce and Microsoft’s competition for LinkedIn as one example. He said Morningstar has seen a lower dollar volume of deals in the Infrastructure as a Service (IaaS) and Platform as a Service (PaaS) markets, but pointed to exceptions such as Twilio in the PaaS sector.

McIlwain says cloud companies are now seeing other routes to funding.

Sheila Gulati

“A few years back, we primarily had strategic M&A as an alternative,” he added. “Now there are financial buyers like private equity firms that will buy later stage private companies. And, they are increasingly international and industrial (GE buying ServiceMax, for example, or the recent acquisition of AI companies by automotive companies).”

The final word on cloud investments comes from Sheila Gulati, managing director of Seattle-based Tola Capital, who suggested that the best kind of venture capital investing comes when those who know and understand the core businesses being served by cloud services are making the investment decisions. So that means that cloud companies really have to understand the sectors they serve.

“Optimal VC investing always maintains a high bar,” she said. “We are seeing more deep technologist and sector expert pairings. This drives more impact as specific business problems get solved in a more focused, and industry-aware manner.”

[Editor’s Note: Salesforce is a GeekWire annual sponsor.]

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Geof Wheelwright has been living "10 minutes into the future" for more than three decades. He covers cloud and IoT technologies, the impact of public policy on innovation - and has been known to write about some things just because they're really, really cool.